The other problem with venture capital: management fees

Bill Gurley posted a really nice summary of one of the main problems with the venture capital industry, and Fred Wilson responded here. I totally agree with their analysis, but would add one more major problem with the venture industry to the list. The fact that most VCs get rich via “management fees” just by showing up every day.

For those who don’t know, most VC’s get paid by so-called 2 and 20. The 2 refers to the 2% of the fund they use to cover operating expenses and pay their salaries. The 20 refers to the (normally) 20% “carry” fee – the percent of the profits they make for their investors that they get to keep.

Now I fully support carry fees – it is very similar to equity in a startup. VC’s should get paid when they make money for their investors.

The problem is the management fees. 2% made sense back when VC funds were much smaller, but not now that they have gotten so large. As peHUB said in their email newsletter today, Benchmark had an $85M fund in 1995 but today has a $500M fund. That seems to be the typical trend for most big VCs.

Let’s do a little math. 2% of $85M is $1.7M. Assuming 8 partners, that means salaries are in the $100-$200K range. Much higher than national averages but, by the standards of finance, they aren’t getting “rich.” 2% of $500 is $10M, so each partner is probably getting $1M+ in salaries. Over the 10 year life of the fund that’s $10M. Even on Wall Street that is considered pretty rich. And they get that money even if they make only bad investments and don’t return a dime to their investors.

This is why you see VCs raising bigger and bigger funds, why you frequently hear them say things like “I need to do 2 deals this year” and, worst of all, why you often see VC’s arguing for larger round sizes even if the startup has no productive use for the additional money – and even for the same percentage ownership. In other words, in many cases VCs argue for a higher valuation just so they can “put more money to work.” Why? If you raise a $500M fund and tell your LPs you are going to invest it over, say, 4 years, then its pretty hard to go back to them after a year and say “thanks for the $10M in management fees, I decided not to make any investments this year.”

VC’s seem to be a big fan of performance-based compensation when it comes to startups. They should adopt it for themselves as well.

http://lmframework.com/blog/about David Semeria

Well said. Quick question: is the management fee usually levied on the full size of the fund, or only the committed portion?
chris

The full size from what I’m told.
thrill

I think it’s a silly complaint – there are a multitude of VCs for an investor to choose from. If he thinks any of the fees are too high relative to the historic performance, then he’s quite free to put his money somewhere else.
chris

I’ve seen VCs argue for higher valuations many times. Are you doubting this happens frequently, or that this isn’t evidence of wacky incentives? VC funds return capital for approx 10 years-it takes a long time for market forces to sort these things out.
Louis

Correct me if I’m wrong, but doesn’t the management fee also cover all the “infrastructure” expenses (IT & telecoms, rent, logistics, etc.) and other salaries (associates, assistants, etc.)

I’d actually love to see a business model for a VC firm, but I think they differ wildly depending on scale and location.
Rob

As a former VC, I think I can shed a little light on some of this. The fees do cover all fund expenses, including a CFO, auditing, rent, travel, etc. However, there is still plenty left over at the end of the year for the million dollar bonuses.
Also, carry and fees are usually related since most funds have to pay back invested capital, plus fees, before they can take carried interest.
@chris is exactly right- it is a huge industry problem, although it usually doesn’t impact entrepreneurs as much as LPs.
The fee % does usually wind down over the life of the fund as it moves from actively investing to harvesting.
Rob

Just to be clear, I never saw anything even close to that kind of compensation, but senior partners can and do.
Steve Kane

Agree 1,000,000% Chris

But @Rob, of course excessive fees impact entrepreneurs as much anybody.

To wit, if fees are at 2% per annum of committed capital, then 16%-20% of the fund goes to fees. LPs should scream bloody murder — that’s QUITE a load! But entrepreneurs are de facto compelled to try to provide venture returns on $1 when they are only given about $0.80 to work with.

The situation is actually even worse — many many funds charge more than 2% (2.5% nearly became the norm last few vintages). Worse, ALL funds require portfolio companies to pay for legal and due diligence costs associated with investments — in my (admittedly rough) calculation, legal and 3rd party due diligence adds up to about 0.5% (50 basis points) of the entire fund, over the life of the fund.
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http://jeremystein.net jeremy stein

vcs arent the only ones with this type of pay structure.

hedge funds, etc, all have a management fee and a carry.

the management fee is supposed to be enough just to keep the lights on.
Dan

I would like to see how many funds are raising, say $500mm and greater, contrasted with how many funds raise less. Especially how many small VC firms are running in the $75-$250mm fund space. The fee seems to make much more sense with smaller funds as a necessity to provide working capital, including “fair” salaries and not inflated salaries. Perhaps it would make much more sense for mega sized funds to slide down on the scale of fees whereas smaller funds maintain the 2%. However, LP’s need to be louder in dictating fee terms. From a fund start-up perspective unless someone has their own money fees are a necessity to operate, especially if you are not a megafund.
http://jeremystein.net jeremy stein

@dan larger funds should have higher cost structures as you need more resources to manage larger pools of capital.

you can definitely earn a nice living on 2%, and i dont doubt that there is often lots of money left over, but i wouldnt want to work (or invest) with any vc who wants to put more money to work in an individual deal (where it is not necessary) or do less deals.
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John

@cdixon

You’re spot on! Bravo for speaking out on this problem. This is a huge problem in the VC/Start Up world.
Interesting how VC”s don’t want to pay “market wages” for start up employees, yet, the VC wages are completely out of whack.
Clearly, the interests are NOT aligned. There are so many hurdles for start up founders and employees and the VC have a “do anything I want” pass.

Bottom line is VC’s should take a salary, but, the upside should come from being good investors. Getting rich of management fees from teachers pensions is pathetic and wrong.
http://www.twitter.com/srevzin Sergei

If a VC can realistically calculate actual “infrastructure” costs, clearly not 2% of total LP investment, there can be little argument against a more reasonable base salary and performance based fee thereafter
chris

john – agree. My guess is good vc’s who actually do make money for the teacher’s pension funds (like Union Square and Benchmark) would welcome trading management fees for carry. The problem is that (approx) 2-20 has become so standardized across VC/PE/Hedge funds that it’s hard to overcome.

It makes no sense to me that someone investing in 2 scientists with an idea should have the same fee structure as KKR.
http://davidcancel.com/ David Cancel

Hallelujah! Hallelujah! Hallelujah! Hallelujah!

Steven Kane has been screaming this from the rooftops here in Boston and I couldn’t agree more.

Amen.
;dc
http://anyclip.com Aaron Cohen

Killer piece. Yet another reason for the contraction that Fred and Bill wrote about the past couple days. Interestingly the new dynamic, I’ve seen is the younger partners or associates realizing the managing partners are kicking back and that it’s killing the firm. Lots of young venture guys get what you’re writing Chris, but they don’t have the internal power to make changes. What can young guys accomplish at General Catalyst, Polaris, Highland to name just a few funds that are huge and paying very, very large salaries to partners?
chris

Aaron – That’s exactly what I’m hearing. A lot of big firms are basically saying “we’ll never get profitable so we might as well just collect management fees and get the junior people off our payroll.” It has happened to a bunch of my friends. I think it’s a really sad situation to happen to an industry (VC) that I love and truly think is the lifeblood of the US economy. One side note – Hemant Taneja at General Catalyst is one of my investors and he works tirelessly (he is also a friend so I am biased but I think everyone who knows him would agree).
http://lmframework.com/blog/about David Semeria

@jeremy stein – yes hedge funds have a simmilar structure – but there is a key difference: you can redeem your investment in a hedge fund with reasonable notice. There is no way a hedge fund could last (or at least not shrink) for 7+ years whilst showing consistently poor performance. It’s true that VC investments take time to mature, but LPs should have the option of no longer committing capital to a fund which (in their estimation) is getting it wrong.
http://dave.postling.com/ David Lifson

Obviously this kind of behavior is not sustainable. A VC firm might be able to collect millions in fees over the life of one fund, but how easy will it be to raise the next fund if they blew the last one?

I wrote about this last month as well – http://www.socialstartups.com/2009/07/20/vc-future/

So I think the market will correct in the long term (but buyer beware in the short term!).
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http://anyclip.com Aaron Cohen

Chris, meant to get back to you on this. I don’t know Hemant so that’s great to hear. But you and I have built some companies (and been through a lot) so we get a different level of access. The 30-year old entrepreneur is much better equipped and trained than I was when I was 30. But they are also facing a savage exit environment that was bad before the recession. Quick name 5 exits in the past 3 years that matter? It’s not that easy. And the recession only started a year ago.

We have many challenges in our ecosystem that need to be addressed. I really want to hang out with you because your platform is gaining traction and can be vital alongside Fred’s and Paul Graham’s and Gurley’s

Aaron
http://www.oyster.com Elie Seidman

Completely agree – it takes a uniquely ambitious (or greedy?) person to get out of bed in the morning and take the right kind of risks when they are already making $1M/yr. It actually creates some very odd risk/reward curves. Take too much risk and you blow up the fund that gives you $1M/yr basically no matter what. Take too little risk and you only make $1M/yr which is not as rich as your other finance friends so maybe it’s best to swing for lots of homeruns instead? The way this all manifests for the entrepreneurs that take the capital from those large funds is that – should those funds have control of the entrepreneurs company – the financial interests of the VC and entrepreneur might diverge massively. The VC has a huge high water mark (the amount of capital they raised from their LPs) that they need to surmount before their carry dollars start to kick in and so they push (or if they control the company, they command) their portfolio companies to “go for broke”. In so doing they are likely to start to ask the management team do to things that the mgmt team has no real desire to do and worse, perhaps they are pushing the company well beyond what is natural achievable in that opportunity.

On a related note, it may well also be that these large funds are one of the causes behind the perception that many people have that it’s a meaningful event for a startup to raise capital. Startups often get a lot of – positive – press for raising a big financing round and people talk about it as if it were something important that was achieved. But liquidation preferences effectively insure that that raised money comes out first; raising VC money only means that you have taken on money that is dilutive (you can’t ever pay it back) and that comes out of the deal before your own money does. While raising outside equity is often value accretive (though always percentage dilutive), the celebration of capital raises is a mistake and needs to be understood for what it is – selling a piece of your company (and perhaps control of the decision making) that you can never get back.
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